EU bank stress-test scenarios for 2014 released

GabrieleSteinhauser

The European Union's banking supervisor on Tuesday sketched out a swath of economic and financial shocks that lenders across the bloc would have to survive to pass stress tests this year.

Under the European Banking Authority's adverse scenario, the EU economy would slip into a two-year recession, shrinking by 0.7% this year and 1.5% next year, and barely grow in 2016. Unemployment across the bloc's 28 member states would reach a record 13% in 2016. House and stock prices would collapse, while interest rates on government and corporate debt would spike.

Starting in May, 124 major EU banks, which make up at least 50% of banking assets in each member state, will test how their investments would hold up in such a crisis. To pass, banks have to maintain a buffer of common Tier 1 equity equivalent to at least 5.5% of risk-weighted assets.

The results are expected in October, just before the European Central Bank takes over supervision of big euro-zone banks from national supervisors.

The EU has presented these stress tests as its final stab at fixing its fragile financial sector, after previous rounds gave pass marks to banks that soon after needed new capital. But the EBA insists that for this year's tests its scenarios are sufficiently gloomy--and sufficiently prescriptive for national supervisors, who will be carrying out the tests--that weak banks will be caught out.

The stress tests will allow "supervisors to address remaining vulnerabilities in the EU banking sector," EBA Chairman Andrea Enria said in a news release.

The ECB in particular has been applying pressure on banks and governments to be better-prepared for potential capital shortfalls. It is currently scrutinizing the balance sheets of big euro-zone lenders, many of whom have been writing down the value of their assets and raising new equity in recent months.

In addition to the recession in the EU, which over the three years included in the tests would take the bloc's gross domestic product a full 7% below current forecasts, banks have to be prepared for a broader global crisis. Growth in its main trading partners--the U.S., China and Russia--would plummet, along with a contraction in other emerging markets and steep currency devaluations in Eastern European countries such as Poland and Hungary.

On top of that, banks have to model the stock-market routs seen during the dot-com crisis of the early 2000s, the Asian market crash and the global credit crunch that followed the collapse of U.S. investment bank Lehman Brothers.

The EBA also made a key change to the methodology it presented in January--countering one of the key criticisms leveled against it in previous stress tests. While the London-based supervisor already said at the time that banks would have to write down sovereign bonds in their trading books to market value, it said Tuesday that banks would now also have to assume losses on some government bonds in their banking books.

Changes in the value of bonds marked "available for sale" will have to be realized gradually, the EBA said, starting with 20% of potential losses this year and going to 60% in 2016.

But despite these changes, there was some concern that the stress tests could be too focused on the origins of past crises, rather than preparing for future risks. For instance, the EBA's scenarios don't include a halt in gas exports to Europe by Russia or the impact of broad economic sanctions against Moscow as a potential result of the current standoff in Ukraine.

They also don't expect the euro zone to experience deflation, where consumer prices fall rather than increase, over the coming three years, despite some concerns among economists that this is a real threat.

Harald Benink, a banking expert at the Tilburg School of Economics and Management, warned that this uncertainty about the future made it especially important that banks raise more capital and that their assets have been written down to a realistic value. "It's always very difficult to know what will be the cause of the next crisis, but that makes it even more important to think about what are the adequate buffers," he said.

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